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Bank of Estonia revises assessment of mortgage applicant borrowing capacity

Apartment buildings on a snowy Kalaranna tänav in Põhja-Tallinn's Kalamaja neighborhood.
Apartment buildings on a snowy Kalaranna tänav in Põhja-Tallinn's Kalamaja neighborhood. Source: Siim Lõvi/ERR

This April, the Bank of Estonia will be amending requirements regulating the calculations made by commercial banks to assess a borrower's maximum borrowing capacity for a new housing loan, compensating for high interest rates resulting from the European Central Bank's (ECB) interest rate hikes.

The change in calculations will mean that despite the prevailing high interest rates, a loan applicant's maximum borrowing capacity will be the same as it was before the ECB's rate hikes. The debt service-to-income (DSTI) ratio limit, however, will remain the same – the sum of all of a borrower's loan and leasing payments may not exceed half of their net monthly income, according to a press release.

Currently, commercial banks in Estonia must assess a borrower's maximum borrowing capacity using either the interest rate in the loan contract in question plus two percentage points or an annual rate of 6 percent, whichever is higher. Beginning April 1, however, the two additional percentage points will be dropped, and calculations will have to apply either the interest rate in the loan contract or an annual rate of 6 percent, whichever is higher.

Rapid base rate hikes over the past year and half have already had a tightening effect on the credit environment, the Bank of Estonia noted. The potential loan volume has also been limited by the two percentage point requirement in calculating monthly repayments. Last November, for example, when banks issued housing loans at an average interest rate of 5.7 percent, they were required to assess borrowers' borrowing capacities at an average interest rate of 7.7 percent.

"The main aim of amending the interest calculations is to ensure that people's borrowing capacity isn't further limited by the additional two percentage points, as market interest rates are already high," explained Jaak Tõrs, director of Financial Stability Department at the Bank of Estonia.

According to Tõrs, if loan growth picks up considerably over the next few years and a loan boom starts looming – indicating that both people and banks have started taking too-great risks, the central bank is prepared to establish more stringent rules again on issuing housing loans.

From a macroprudential perspective, the Bank of Estonia deems it reasonable and sufficient to set the DSTI limit at the highest average loan market interest rate seen in the interest rate cycle, which is 6 percent.

When assessing the credit capacity of a single borrower, the banks still have to abide by the Estonian Financial Supervisory Authority's guidelines that require performing sensitivity analyses in which a potential future rise in interest rates is taken into account.

The central bank also specified DSTI requirement calculations in case of special repayment schedules. As such loan contracts allow the principal amount of a housing loan to be repaid in later years, the borrower is able to take out a bigger loan in relation to their income.

The Bank of Estonia's requirements state that if the housing loan is not repaid as annuity or equal principal payments, the sum of the monthly principal and interest payments of such a loan must be calculated as the average over the entire loan contract period.

The goal is to ensure that the loan burden does not become excessive even in case of special schedules, the bank explained.

The Bank of Estonia also provided two example scenarios to illustrate how the interest rate component in DSTI calculations will change with this update.

In the first example, if a bank wants to issue a housing loan at an interest rate of 5.7 percent, then under current rules, the interest rate for loan payment calculations must be calculated as 5.7 percent plus two percentage points, i.e. 7.7 percent, as this sum exceeds the alternative 6 percent. After dropping the additional two percentage point requirement beginning in April, however, the interest rate for calculating loan payments will be 6 percent instead, as this exceeds the 5.7 percent rate.

In the second, if a bank wants to issue a housing loan at an interest rate of 6.2 percent, under current rules, loan payment calculations would call for a total interest rate of 8.2 percent. Beginning in April, calculations will be based on the 6.2 percent rate alone.

Beginning in 2015, the Bank of Estonia established minimum requirements for issuing housing loans to which commercial banks operating in Estonia must adhere. These requirements were intended to ensure that banks and borrowers as a whole would not take too high of risks, thus ensuring the sustainable functioning of the country's economy as a whole.


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Editor: Aili Vahtla

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